Coming Back From the Beach (Part II)

In Going to the Beach, Part I, Nathan talked about what to do when it's time to "grab the beach towels and sand shovels" - taking a trading time-out when a total portfolio stop loss is hit.

Now, in "Coming Back From the Beach," he'll guide you on how to make your return…

- JS

So you voluntarily - or at the suggestion of others - went to the beach. All positions have been liquidated, and you have disconnected from markets.

From this point, the next steps you take could determine whether you persevere, or it call it quits in the trading world.

What are the key steps / thought processes you must go through now?

1) Disconnect for at least two weeks (if not two months)

Before you go back to trading, you are going to need to analyze what (if anything) went wrong. It is hard to do this with existing positions still in play, and it is my opinion you need to have your mental batteries fully recharged as well.

If you are a chart trader, for example, a few weeks away can give you better clarity, and the focus needed to take an unbiased approach with respect to past trades. Bring up new charts, with none of your old markings, and analyze the markets from a fresh perspective. This is hard to do if you are fully invested psychologically in the markets.

If you are a mechanical trader, the steps will be a bit different (assuming you followed your system 100%). We will cover that in more detail later.

And if you are a fundamental trader, you might need to reassess your approach to interpreting financial information, or how you value securities.

2) Review your past trades to determine what went wrong.

Taking the chartist as an example: With new, unmarked charts in front of you, assess whether the trades you took actually met your requirements. Some of the questions you might ask are as follows:

Now you have to be careful here, as "after-the-fact" trading is not the purpose of this exercise. Almost all charting software can bring up a chart that makes the proper decision look easy in hindsight. You can't look at a chart and say, "Oh, well now that the false break-out occurred, my support line was no longer valid," if the false breakout was still future information at the time of the trade.

You must also consider the accuracy of your method and your consistency in sticking to the rules. If your trading plan says that you must have three touches to validate a support area, but you took a trade with only two touches, then you failed to follow YOUR rules.

There is an important distinction here… the fact that a trade lost money does not necessarily mean you screwed up. If you followed your trading plan, obeyed your rules and risked a percentage of capital that was within guidelines, but lost money on the trade anyway, you can move on to the next trade. You did nothing wrong and I applaud your discipline.

"Did I follow my filter criteria before putting on the trade?"

Whether mechanical or discretionary, most traders have entry filters that consist of elements like the following:

For mechanical traders, it is very easy to answer this question. Either you took the trades as determined by the system, or you didn't. Correlation, and any of the filters listed above, should be part of the system. The benefit of using a mechanical system is the black-and-white nature of it. You were disciplined and followed your system, or you deviated for whatever reason - there is no gray area.

When traders go through the analysis steps above, the majority will typically find they were at fault. They jumped the gun on trades, altered their rules (discarding or changing an exit strategy perhaps), disobeyed their filters, altered their risk parameters, or didn't take valid signals.

It is by no accident that all of the above falls under "lack of discipline." I would guess most beach visits are a direct result of lack of discipline, specifically risk management discipline. Instead of reducing risk as drawdowns occur, the natural tendency is to ramp things up to make back what was lost. This "technique" simply adds momentum to the drop. Many times, before the trader even knows what happened, a manageable single digit loss percentage balloons into the high teens or even 20%+ area.

In other instances, the trader may have followed his plan 100% but was simply subject to a catastrophic event beyond his conntrol. If he or she trades equities, there could be a gap opening that turns a 1% loss into a 6% loss. If the trader is short oil futures, a world event might cause a spike that locks a position in limit-up.

As mentioned, if you followed your trading plan 100% I applaud you. If you suffered only as a result of market extremes, rather than lack of discipline, you may be ready to get back in the saddle. And even if that was the case, the "beach time" may have served well in terms of mental focus, analyzing what went wrong, and determining what was out of your control.

4) Modify your approach / system (if needed)

If you stuck to your trading plan and still got beached, you may have critical weaknesses in your approach. It could be as simple as adjusting a rule or adding a new set of filters, for example in regard to earnings releases. Or you may need to modify the strategy on a deeper level going forward.

If you are a mechanical trader and followed your system 100%, you want to be careful here. If the drawdown fell within historical averages, there may be nothing wrong other than that market conditions were temporarily not advantageous to your strategy. Trend followers, for example, can expect to take losses in periods of choppy, trendless markets. Day traders who thrive on volatility may have trouble when markets go flat with little movement, and so on.

As a mechanical trader, I warn you against trying to "optimize" your way out of a drawdown. The biggest mistake you can make is going back to a specific time period, and then curve-fitting your new adjustments to the past to try and avoid drawdown. It is possible to make any past time period look better with the right combination of filters and conditions. The problem is that curve-fitting to the past only works if those exact same conditions happen again. When you take a curve-fit strategy and test it over 30 years of data, you quickly see the problem with this train of thinking.

I have no problem with looking for improvements to your system, but there is a line you want to avoid crossing. The more "robust" the system, the better, meaning that, on balance, the system works in all markets over extended periods of time. The shorter the time frame and smaller the trade sample size you use for your improvement testing, the higher the risk of accidental curve-fitting.

Look at only a handful of the mechanical systems out there - especially the ones you see advertised in trading magazines - and you will see many that show amazing results trading just 5 ETFs or 5 commodities over a specific time window. If you have to narrow the trading pool down to 5, for a specific length of time, there is usually a reason why. The act of deliberately focusing on the best-looking results from past simulations, instead of considering all results, is called cherry-picking.

One final note: In order to effectively analyze performance, you need to know how to track it. We can cover the basic metrics of for that in a future article.

Nathan O (nathan@mercenarytrader.com)

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